The summer of 2007 was an interesting one. Different aspects of the debt market were hot with investors and Wall Street couldn’t get enough of them. Collateralized Debt Obligations (CDO) and junk bonds were both getting gobbled up by investors looking for better yields.
This morning while combing through different news sites, two different articles on Bloomberg caught my attention. The first one was regarding collateralized loan obligations (CLO). Does that sound a little too much like CDO? Instead of debt obligations back by collateral like a home, these instruments are very similar. They are packaged debt products and CLOs are packaged corporate loans.
According to the Bloomberg article, the demand for CLOs is so strong that it is creating greater risk. “That strong demand is allowing managers to sell CLOs with weaker protections, and it’s making the leveraged loans that get bundled into the securities riskier too,” the article stated. It went on to say that projections are for a record $150 billion of new CLOs being issued in 2018.
All of that sounds way too much like the market for CDOs back in early 2007—packaged debt products, incredible demand for them, record issuing rate…
Junk bonds are also seeing strong demand and that was the subject of the second article. According to research from Goldman Sachs, the demand has been so great that it has pushed the risk premiums down to levels not seen since June 2007. The article included the chart below that shows the spread between high yield bonds and investment-grade bonds.
I don’t know about you, but I get a little nervous when I see comparisons between current situations and the circumstances that built up before the financial crisis. It was in the summer of 2007 when the credit markets started tightening up and that was the beginning of the mess.
I remember making an appearance on CNBC on Labor Day weekend in 2007, right as the credit markets were locking up. I was listening to the conversation between two analysts as I was waiting to go on air. The two analysts were in agreement that the situation would impact the financial sector, but it wouldn’t spread to the other sectors.
The credit market wasn’t part of the discussion when I was on the air, but I remember writing an article later that day. My argument was that if the credit market locked up, it would impact every sector and the economy as a whole because at the time we essentially had a negative savings rate in this country. If the credit markets locked up, this would drive the economy into a recession as consumers wouldn’t have the credit to continue their old spending habits and they didn’t have the savings to fuel growth.
Flash ahead 11 years and things are looking eerily similar. The personal savings rate fell to 2.4% in 2017 and that is lower than it was in 2007. Apparently consumers didn’t learn anything from the financial crisis.
I am not suggesting that the credit markets are going to lock up again and cause another financial crisis. What I am suggesting is that you should keep an eye on indicators and make adjustments to your portfolio allocations.
In December the sentiment toward the market was too bullish and I suggested lowering your stock allocations. Now I am watching Consumer Confidence to see if and when it starts falling. I will also be watching the main indices to see if we experience any bearish crossovers. With each one of these events, should they occur, I will ratchet down my equity allocation by 5-10% and maybe more. I suggest you take a similar approach.